Fortinet, Inc. — Q2 2018 Form 10-Q Summary
Reporting period: Quarter and six months ended June 30, 2018. Amounts are in U.S. dollars; financial statement figures are in millions unless noted.
Business context
Fortinet sells cybersecurity hardware and software, principally through distributors and resellers, along with FortiGuard security subscriptions and FortiCare technical support. It reports one operating segment. The company cited growth in FortiGate shipments, Security Fabric and cloud products, and recurring service revenue.
Key financial metrics
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $441.3 (+21%) | $363.5 | $840.3 (+19%) | $704.0 |
| Product revenue | $166.3 (+17%) | $142.7 | $309.1 (+11%) | $277.9 |
| Service revenue | $275.0 (+25%) | $220.8 | $531.2 (+25%) | $426.1 |
| Gross margin | 74.4% | 73.7% | 75.0% | 73.6% |
| Operating income | $50.7 (+78%) | $28.5 | $83.1 (+145%) | $33.9 |
| Net income | $49.3 | $23.0 | $90.9 | $33.7 |
| Diluted earnings per share | $0.28 | $0.13 | $0.53 | $0.19 |
| Operating cash flow | $142.2 | $144.8 | $282.0 | $274.5 |
| Free cash flow (non-GAAP) | $130.6 | $58.4 | Not stated in the cited comparison | Not stated |
Q2 service growth reflected FortiCare and FortiGuard demand; service gross margin rose to 85.7% from 84.2%. Product gross margin declined to 55.6% from 57.4%, attributed to product mix, product transitions and contract term. Higher service margins lifted total gross margin.
Financial position and liquidity
- Cash and cash equivalents were $972.1; short- and long-term investments were $526.9, for total cash, cash equivalents and investments of $1.499 billion, up from $1.349 billion at year-end 2017. Working capital was $799.6.
- Deferred revenue was $1.471 billion, up 10% from December 31, 2017; remaining performance obligations were also $1.47 billion. Fortinet expects to recognize about 80% over the next one to two years.
- Total assets were $2.576 billion and total liabilities $1.796 billion. The balance sheet shows no separate borrowings line; $9.5 million of debt assumed in the Bradford acquisition was repaid during the half-year.
- Six-month investing cash use was $18.5, including $23.2 of capital expenditures and $6.0 net cash paid for Bradford, partly offset by investment maturities and sales. Financing cash use was $102.4, including $117.1 of share repurchases.
Material changes and comparability
Fortinet adopted ASC 606 on January 1, 2018 using the modified retrospective method; prior-year figures were not restated. Adoption increased reported Q2 revenue by $5.2, operating income by $17.2 and net income by $13.2 versus the company’s estimate of results under the former standard. For the first half, the corresponding increases were $11.6, $33.8 and $26.0. A major element is capitalization and amortization of certain service-contract sales commissions rather than expensing them upfront; this reduced sales and marketing expense by $11.8 in Q2 and $23.5 for the half-year. Consequently, reported year-over-year profit and margin growth is not fully comparable on an unchanged accounting basis.
Other changes included a preliminary $6.8 million acquisition of Bradford Networks in June, adding $10.5 of goodwill and $8.8 of identifiable intangibles while assuming $12.5 of net liabilities. Fortinet repurchased 2.5 million shares for $117.1 during the first half. In July, the board authorized an additional $500 million of repurchases and extended the program through December 31, 2019, bringing total authorization to $1.5 billion.
Outlook, commentary and risks
- Management gave no specific revenue or earnings guidance in the filing. It expects research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2018; it plans continued investment in product development, sales capacity and marketing.
- Construction of a new Sunnyvale headquarters is expected to start in Q4 2018. Estimated spending on the project during 2018 is $10–$20 million, with spending continuing into 2019 and through completion.
- Management said existing cash and investments should meet anticipated needs for at least 12 months. $915.7 million was held by international subsidiaries; the company expected to repatriate an additional $150 million during the rest of 2018, subject to restrictions including Singapore dividend rules and tax effects.
- Key risks include dependence on channel partners and distributor concentration: Exclusive Networks represented 29% of Q2 revenue and 32% of receivables at June 30. Other stated risks include quarterly order timing, competition and pricing, component supply and inventory management, foreign exchange, cybersecurity/product defects, international regulatory and trade developments, and execution of cloud and enterprise growth strategies.
- Fortinet was in settlement discussions with the U.S. Attorney’s Office regarding an ongoing inquiry into Trade Agreements Act compliance. The filing says litigation outcomes are not determinable and that adverse intellectual-property litigation could affect margins. A French tax audit and an Israeli tax audit were also disclosed. The company was evaluating the impact of a July 2018 Ninth Circuit tax decision.
- The effective tax rate was unusually low: 4% in Q2 and a 3% benefit for the first half. Management attributed this partly to the lower U.S. federal rate and releases of uncertain-tax-position reserves, including an $18.0 million release for the first half. The rate may vary with discrete items and tax-law developments.
Important facts for investors to verify
- Assess underlying growth and profitability using the Topic 606 comparison, especially its material effect on reported operating income and sales commission expense.
- Track billings, deferred revenue, service renewals and remaining performance obligations alongside GAAP revenue; Q2 billings were $513.4, up 20% year over year.
- Monitor distributor concentration, receivable collection and channel inventory, particularly exposure to Exclusive Networks.
- Review the outcome and potential financial exposure from the Trade Agreements Act inquiry, tax audits and intellectual-property matters; the filing does not provide a clear quantified loss estimate for these contingencies.
- Compare future cash generation with planned share repurchases and headquarters spending, and confirm the timing and tax implications of overseas cash repatriation.